Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
Today I am working in Dubbo, which is in the western region of NSW and getting into the remote parts of the state. There is a great beauty to enjoy in remote Australia which often passes people by. My field trip is in relation to continuing work I am doing with indigenous communities in this region. I will report on this work in due course. But today’s blog continues the theme I developed yesterday on bank reserves. In yesterday’s blog – Building bank reserves will not expand credit – I examined the dynamics of bank reserves but left a few issues on hold because I ran out of time. One issue is the possible impact of expanding bank reserves on inflation. This is in part central to the mainstream hysteria at present about the likely legacies of the monetary policy response to the crisis. The conclusion is that everyone can relax – the only problem with the monetary policy response is that it will be ineffective and more fiscal policy effort is required.
This blog is intended to conclude the two-part series I started yesterday on bank reserves. It will also serve to clarify – by expressing in a different way – some of the essential principles of modern monetary theory (MMT) which are developed in Deficit spending 101 – Part 1 | Deficit spending 101 – Part 2 | and Deficit spending 101 – Part 3 – plus other blogs. Go to Debriefing 101 for a collection of blogs covering the first-principles of MMT.
In yesterday’s blog – Building bank reserves will not expand credit – I used a recent working paper from the Bank of International Settlements – Unconventional monetary policies: an appraisal – to explain some of the operational aspects of the monetary system which are at the core of MMT and which mainstream macroeconomics fails to depict in any coherent manner.
The specific context was Paul Krugman’s on-going policy suggestion that quantitative easing is required to stimulate lending. I showed that QE is largely incapable of stimulating lending and not surprisingly because lending is not reserve constrained. The conclusion was that Krugman clearly doesn’t understand the banking operations that link monetary policy to bank reserves. Developing this understanding is a core differentiating feature of MMT.
The use of the BIS research paper was deliberate because it demonstates that the banking professionals also understand key components of MMT even if they use language conventions that appear to place them in the mainstream discourse. To further demonstrate this I will continue to examine this BIS working paper in the context of the impact of bank reserves on interest rate policy and the potential for inflation.
In normal times (that is, not during this significant economic crisis) monetary policy is “defined exclusively in terms of a short term interest rate” where the central bank signals that it will set a “policy rate” – this is the central bank’s estimate of the rate that will achieve its policy goals. However, the central bank then has to engage in liquidity management operations:
… to help make that interest rate effective: they ensure that a market “reference rate”, typically an overnight rate, tracks the desired interest rate level closely. As such, liquidity management operations play a purely technical and supportive role.
To understand MMT it is important to link the idea of the liquidity management operations in the monetary policy domain to the impacts of government spending and taxation arising in the fiscal policy domain. If you read any mainstream macroeconomics textbook the linking of these two domains is not made in any coherent way. In fact, because the two domains are mis-specified in that paradigm, false conclusions are drawn (for example, they claim that fiscal deficits cause interest rates to rise).
When the government spends it credits bank accounts (or issues cheques which end up in the bank settlement system) and after all the transactions are completed the result is that bank reserves expand. Conversely, when the government collects taxes it debits bank accounts (or accepts cash/cheques) and this results in a $-for-$ decrease in bank reserves.
These are vertical transactions between the government and non-government sector and thus create or destroy bank reserves. Logically, when the government runs a fiscal deficit (spending is in excess of tax receipts), the impact on bank reserves is a net positive – reserves expand in net terms. Conversely, when the government runs a fiscal surplus (spending is less than taxation receipts), the impact on bank reserves is a net negative – reserves contract in net terms.
It is essential to understand these impacts because they allow you to then understand the way in which the liquidity management operations conducted by the central bank, though separate from fiscal policy, are intrinsically linked to these impacts.
The link is created not because the fiscal position adopted by the government “has to be financed”. That is the common error that mainstream macroeconomics textbooks make. A sovereign government that issues its own currency does not need to finance its spending. That is so obvious that it continually surprises me that commentators persist in asserting the opposite.
All the financial machinations (debt-issuance, taxation) that might look on the surface to be “financing operations” are in fact nothing of the sort. The following discussion will clarify the role that debt-issuance serves in the monetary system. The rhetoric of the government might lead one to conclude otherwise (that debt-issuance is a financing operation) but the hard reality of the daily liquidity management operations (once understood) reveal the truth – the separation of political stance from reality.
The BIS say that:
The fulcrum of the implementation of interest rate policy is the market for bank reserves. This is a peculiar market. By virtue of its monopoly over this asset, the central bank can set the quantity and the terms on which it is supplied at the margin. As such, the central bank is able to set the opportunity cost (“price”) of reserves, the overnight rate, to any particular level, simply because it could stand ready, if it so wished, to buy and sell unlimited amounts at the chosen price. This is the source of the credibility of the signal.
Crucially, the interest rate can be set quite independently of the amount of bank reserves in the system. The same amount of bank reserves can coexist with very different levels of interest rates; conversely, the same interest rate can coexist with different amounts of reserves. What is critical is how reserves are remunerated relative to the policy rate. We refer to this as the “decoupling principle”. It is a principle that has far-reaching implications for the rest of the analysis.
The signal they refer to is the announced policy or target rate. You will note that the central bank (as an integral component of the consolidated government sector with treasury) also does not have a revenue-constraint – it can buy and sell unlimited reserves at whatever price it chooses to set.
The decoupling principle was examined in yesterday’s blog – Building bank reserves will not expand credit. The following discussion clarifies the statement that “what is critical is how reserves are remunerated relative to the policy rate”.
The BIS use the following figure to motivate this discussion. It appears on Page 4 of their paper . It is a good way to understand how different reserve remuneration schemes operate in relation to monetary policy and the profit-seeking aims of the commercial banks.
There various parameters in the figure are defined as follows:
- rp = the central bank monetary policy rate – which is the rate that the central bank believes will advance its policy goals.
- ro = the overnight rate which is established by supply and demand of reserves in the interbank market, which allows the commercial banks to dispose of or acquire overnight reserves. In the case of a system-wide excess the transactions in the interbank market are unable to clear the excess. In this case, only a draining operation (selling government bonds) by the central bank will eliminate the excess. Similarly, when the is a system-wide shortage of reserves, only a central bank injection can make up the shortfall, irrespective of the positions held by the individual commercial banks.
- rE = the rate that the central bank pays to the commercial bank for excess reserves left in the system overnight.
- Rmin = the minimum amount of reserve balances required for settlement purposes. Banks keep this amount so that all daily transactions that require transfers of reserves between banks can be settled in an orderly manner.
- R* = the amount of reserves in equilibrium. This is achieved when the banks have the minimum reserves required for settlement purposes and they are earning a competitive rate on any further reserves. Equilibrium implies that there is no further transactions in the interbank market.
How do we interpret this figure?
There are two schemes shown (Scheme 1 and Scheme 2). Scheme 1 refers to the normal situation where the central bank sets the support rate (rE) that it pays on overnight reserves below the policy rate (rp). In Australia, the support rate is typically 25 basis points below the target rate. In New Zealand, the RBNZ has set the rE = rE. Until recently, the Bank of Japan and the US Federal Reserve set rE = 0.
In the monetary system described by Figure 1 there are no reserve requirements with averaging provisions imposed. So according the BIS authors the:
… amount of reserves that banks need to hold overnight, Rmin, is determined entirely by banks’ settlement needs, including any precautionary element. This demand depends on the wholesale settlement arrangements in place, and is in effect independent of the interest rate.
Accordingly, the demand for excess reserves by banks (DD) is vertical (that is, invariant to the short-term (overnight) interest rate) because banks will desire to hold minimum reserves (Rmin) to ensure they can meet the demands of settlement each day. That level is not a function of the interest rate. The central bank has to ensure this minimum amount is always available irrespective of the remuneration approach it adopts with respect to excess reserves. If the central bank fails to provide this level of reserves then “significant volatility of the overnight interest rate” would result.
The BIS elaborate:
Any excess would drive it to the floor set by the remuneration on excess reserves (zero or the rate on any standing deposit facility), as banks seek to get rid of unwanted balances by lending in the overnight interbank market. Any shortfall would lead to potential settlement difficulties, driving the rate to unacceptably high levels or to the ceiling set by end-of-day lending facilities. Once the demand for bank reserves has been met, the central bank can set the overnight rate at whatever level it wishes by signalling the level of the interest rate it would like to see.
So how does the remuneration scheme matter? Under Scheme 1, profit-seeking banks will attempt to economise on excess reserves above the minimum required for settlement purposes because the “support rate” is below the overnight rate.
If there are excess reserves (greater than Rmin), the “existence of an:
… opportunity cost of reserve holdings (ro – rE) implies that when excess reserves exceed Rmin, banks will attempt to lend out this surplus. In so doing, they will drive the overnight rate down to rE. At this point the opportunity cost is eliminated.
So whenever there are reserves beyond the minimum required for settlement purposes, the banks will seek to lend these reserves out in the interbank market to get a return above rE (the support rate paid by the central bank). If rE = 0 then this competition for loans in the interbank market will drive the overnight rate to zero if left unchecked by the central bank.
The clear implication is that the central bank then loses control of its target short-term interest rate (rp > ro). In these instances the central bank has to intervene to choke of the interbank activity and it does this by offering the commercial banks an alternative near-equivalent asset to the bank reserves which earns a return commensurate with rp. This asset is a government bond. So debt-issuance is properly understood to be a means by which the central bank maintains control of its policy target interest rate.
Under Scheme 2, the central bank pays the commercial banks a return on excess reserves (above the minimum required for settlement purposes) equivalent to the policy rate. In this case:
…. there is no opportunity cost of holding excess reserves and banks will be indifferent about the amount of reserves they hold as long as the minimum for settlement purposes is satisfied.
So in this case there is no need to sell public debt to the commercial banks. By setting the support rate equal to the policy rate the central bank is offering the equivalent to the a government bond to the commercial banks. The payment short-circuits any need the commercial banks have to eliminate their exceess reserve holdings and they will happily sit with large stocks of reserves instead of seeking alternative interest-bearing assets (such as public debt).
The other important point to connect relates to the impact of fiscal policy on the reserves. We know that fiscal deficits create excess reserves. In this case, they create a dynamic in the liquidity (or cash) system whereby the interest rate is bid down via interbank market competition (as above). This forces the central bank to issue debt to the commercial banks (to drain the reserves) or pay a support rate equivalent to the policy rate if it wants to maintain that particular monetary policy stance.
Under these circumstances, the debt-issuance stops the interest rate from falling to the support rate in the face of budget deficits. Budget deficits per se do not put upward pressure on interest rates. The monetary operations associated with the liqiuidity management operations stop the interest rates from falling but that is a different matter altogether.
Once you understand all that you will also grasp why the relevant chapters in mainstream macroeconomics textbooks and most of the so-called informed commentary on fiscal and monetary policy is erroneous in the extreme.
Bank reserves and inflation
Later in the paper, the BIS authors examine the question: “Is financing with bank reserves uniquely inflationary?” Recall, in yesterday’s blog – Building bank reserves will not expand credit – we noted that Paul Krugman was advocating quantitative easing again as a desirable policy at present because it would promote expectations in the private sector of future inflation. He constructed QE as an expansion of bank reserves.
The inflationary expectations would, in turn, lead “savers and investors” to conclude that real interest rates, in an environment of zero or very low nominal interest rate, would become negative. This would according to Krugman stimulate the demand for bank loans and help kick-start the economy.
So an essential part of the argument is the build-up of bank reserves is inflationary.
The BIS authors say:
The proposition that highlights the inflationary consequences of financing via bank reserves is closely related to the first. If bank reserves do not contribute to additional lending and are close substitutes for short-term government debt, it is hard to see what the origin of the additional inflationary effects could be. The impact on aggregate demand, and hence inflation, would be very similar regardless of how the central bank chooses to fund balance sheet policy. For example, it is not clear how inflationary pressures could be more pronounced in a banking system that keeps its liquid assets in the form of overnight deposits at the central bank compared to one that holds one-week central bank or treasury bills.
The same would apply to concerns about the “monetisation” of government debt, whereby the central bank purchases government bonds either in the primary or secondary market. Here the issue is whether the financing of government expenditures through the creation of bank reserves, quite apart from the boost to aggregate demand associated with expansionary fiscal policy, would lead to inflation or not.
First, you can see that while the BIS authors understand the operations of the banking system they are not operating within the MMT paradigm. The use of terminology such as “financing medium” tells you that. The use of this terminology, while conventional among bankers such as this, is highly misleading. The central bank does not “finance” government spending by creating bank reserves. Bank reserves are created by public spending which, as we discussed above, present the central bank with some choices depending on its monetary policy stance. The monetary operations conducted by the central bank are not “financing” operations but rather they are correctly understood to be liquidity management operations.
Further, the idea that the central bank can monetise public spending and maintain a positive interest rate target (and pay a support rate below the policy rate) is impossible. If the central bank tried doing this, the competition in the interbank market as banks tried to shed their excess reserves would lead to the central bank losing control of its policy rate. It would have to sell public debt to drain the excess reserves or increase the support rate on excess reserves to the policy rate. You will not get an understanding of this sort of reasoning in any mainstream macroeconomics textbook or research article.
Second, in Building bank reserves will not expand credit – we showed that an expansion of bank reserves will not increase bank lending. The idea that it would is based on the flawed understanding that banks need reserves before they will lend. Categorically, they do not. Mainstream macroeconomics textbooks are completely wrong in that regard.
In this context, it is essential to understand that the analysis of inflation is related to the state of aggregate demand relative to productive capacity. Credit growth manifests as increased spending. In itself that is not inflationary. Nominal spending growth will stimulate real responses from firms – increased output and employment – if they have available productive capacity. Firms will be reluctant to respond to increased demand for their goods and services by increasing prices because it is expensive to do so (catalogues have to be revised etc) and they want to retain market share and fear that their competitors would not follow suit.
So generalised inflation (as opposed to price bubbles in specific asset classes) is unlikely to become an issue while there is available productive capacity. Even at times of high demand, firms typically have some spare capacity so that they can meet demand spikes. It is only when the economy has been running at high pressure for a substantial period of time that inflationary pressures become evident and government policy to restrain demand are required (including government spending cutbacks, tax rises etc).
Further, spending growth can push the expansion of productive capacity ahead of the nominal demand growth. Investment by firms in productive capacity is an example as is government spending on productive infrastructure (including human capital development). So not all spending closes the gap between nominal spending growth and available productive capacity.
The BIS authors then examine the inflation issue in the context of the remuneration rate offered to commercial banks by the central bank.
In the case where excess reserves are remunerated at a rate that is below the policy rate, their injection would push overnight rates down to the floor established by the remuneration rate on any deposit facility, possibly zero (scheme 1). This is tantamount to an easing of interest rate policy. As a result, any ensuing inflationary pressure can be largely attributed to the usual expansion of aggregate demand that accompanies such a move.
So it is not the monetary policy setting but rather the final spending in excess of productive capacity that causes inflation. However, this would depend on how sensitive aggregate demand is to interest rate movements. In maintstream economics, spending is assumed to be relatively sensitive to changes in interest rates which is why they advocate inflation targetting to discipline the inflation process.
In MMT, there is less confidence that changes in policy interest rates within normal ranges alter spending dramatically. One has to realise that there are two sides to consider. The cost of funds side – whereby an increase in the interest rate will possibly reduce the demand for funds (for a given expectation of revenue flow arising from the investment) – and the income side – whereby an increase in the interest rate provides a boost to fixed income recipients and may, in turn, boost spending. This would impact back on investment because investors would not only face higher costs of borrowing but would likely feel more confident about future income flows.
So these distributional complexities make it difficult to conclude unambiguously that interest rate changes are an effective way to manipulate aggregate demand. They also work more slowly and indirectly anyway and make it very hard to disentangle from other impacts on demand.
The point is that the sale of public debt in Scheme 1 will drain excess reserves and prevent the overnight rate falling below the policy rate. In that sense, there would be no inflationary impacts (irrespective of how sensitive aggregate demand is to changing rates).
In terms of Scheme 2 (support rate = policy rate), the BIS say that:
In the case where excess reserves are remunerated at the policy rate or interest rates are already at the zero lower bound, so that the opportunity cost of excess reserves is zero, their expansion would not affect overnight rates (scheme 2). To the extent that any additional impact on inflation existed, it would result mainly from the effect on aggregate demand of a flatter yield curve that the quasi-debt management operation may induce. For example, if the central bank were to inject reserves through the acquisition of long-term government bonds, the net impact on yields and inflation would not be dissimilar to the rebalancing of government financing from long to very short maturities. In fact, such an “operation twist” can be achieved by the fiscal authorities themselves.
So while this might sound complex, it is saying nothing more than changes to long-term rates may stimulate investment which, in turn, might drive nominal spending growth faster than the real capacity of the economy to absorb it.
In other words, any inflationary effect that might arise comes from the spending side and is not intrinsic to the way the central bank conducts its liquidity management operations.
The BIS authors also consider so-called monetisation;
More generally, inflationary concerns associated with monetisation should be largely attributed to the impact on aggregate demand via a fiscal policy that is accommodated by the monetary authorities, who refrain from raising rates. That is, it is not so much the financing of government spending per se (be it in the form of bank reserves or short-term sovereign paper) that is inflationary, but its accommodation at inappropriately low interest rates for a sustained period of time. Critically, these two aspects are generally not distinguished in policy debates because the prevailing paradigm has failed to distinguish interest rate from balance sheet policy. Given the pervasive assumption of a well behaved demand for bank reserves, one is seen as the dual of the other: more reserves imply lower interest rates. But, as we have stressed all along, this is not the case. And the decoupling of interest rate from balance sheet policy during the current crisis has simply confirmed this again.
See my comments above on monetisation. This could only occur if the policy rate was already at zero or the support rate was equal to the policy rate. In that case, a build up of reserves would accompany the net fiscal injection but as we have seen above – this has nothing intrinsically to do with what happens to spending growth in relation to the real capacity of the economy.
If aggregate demand is relatively insensitive to interest rate settings then this point has not relevance either. It is clear, however, that if interest rate changes do impact on spending such that low interest rates are more expansionary than higher interest rates, then a fiscal expansion and a zero interest rate policy will be stimulatory. The issue is not that this will be intrinsically inflationary as is asserted by the mainstream.
It just means that the extent of the fiscal injection that is required to achieve full capacity utilisation is reduced. The government always has the capacity to balance aggregate spending to match the capacity of the economy to absorb it.
I wrote this blog and yesterday’s blog to provide some further discussion of some of the main tenets of MMT. By using a BIS working paper as motivation I was able to use “their language” to demonstrate these essential underpinnings of MMT. Using different language sometimes helps overcome mindsets and broaden one’s understanding of a fairly complicated subject matter.
But what should be very obvious to anyone is that the mainstream macroeconomics textbook depiction of the monetary system and how fiscal policy uses it and impacts on it are totally erroneous. Students who only engage with these textbooks and lecturers that use them will leave their studies with a false impression of how the system functions.
Some of them get jobs in policy making areas of government and take this erroneous view of the system with them. It is no wonder that we get poor policy responses and ridiculous speeches written for the political leaders.
Others who graduate become journalists and you can then see the problem that arises from that.
I received an E-mail overnight from my mate Marshall Auerback who was recently visiting Newcastle and who writes for the New Deal blog published by the Roosevelt Institute. He thought the BIS research paper was an important contribution because it is written by non-MMT economists who clearly are operating within the mainstream paradigm (note their use of the financing nomenclature) but who understand the monetary operations that govern real world financial systems.
Marshall noted the quote that I provided from the BIS report:
In order for the funds (bank held reserves) to be inflationary they must be borrowed and spent.
His response was as follows and I thought worthy of quoting in its entirety. It shows I do get interesting E-mails (-:
That is a point I have tried to make clear with the Austrian brigade and the deficit doves, amongst others. There is no magical mechanism that reprices goods and services with any given change in the money stock. Money does not chase goods. That is mystification – money is not an agent that can take action on its own. Nor is there any such thing as “the market” – there are people behaving and acting within the strictures of market mechanims. People borrowing and spending money pay prices for goods and services (and assets, financial and tangible). If money (qua reserves) is created but not borrowed and spent there is simply no market mechanism that automatically and mystically changes all product prices. There may be a change in relative supplies, but there is no market where this automatically yields a change in relative prices except the product market themselves, where sellers make offering prices and buyers bid on goods and services.
The BIS has been one of the few official agencies willing to think and write and advocate clearly about financial balances and financial stability. My fellow Canadian William White’s legacy, carried on by Claudio Borio and others, is in no small part responsible for this. With this document you have surfaced, they now openly shatter some more mainstream macro illusions. Very big steps forward … but won’t stop Krugman from misfiring, and doesn’t mean they are yet willing to sign on to MMT … but they are getting much closer to the truth.
A good way to end and rush to the airport to catch my plane to … Dubbo. Hard place to get to from Newcastle – 3 hour train to Sydney airport then plane out west.